Sunday, 23 March 2008

Troubles with derivatives in the financial sector

I am still convinced that the credit derivatives bomb is slowly ticking in the financial services market, ready to explode and hit all other sectors of the US and global economies. For some extra recent info on the CDS topic, read Swaps Backers Rush to Prevent 'Credit Event' from the Financial Week publication about the recent developments in credit default swap ("CDS") markets, or read The Credit Default Swap ("CDS") Market – Will It Unravel? which gives a nice overview of what is going on in the CDS markets.

In this regard, a very interesting statistical publication is the Quarterly Report on Bank Derivatives Activities published by the Office of the Comptroller of the Currency ("OCC"), the U.S. regulator and administrator of U.S. national banks and their activities. It is a very useful piece of information which allows one to assess risks of certain U.S. banks. The latest available report as of March 23, 2008 is the Third Quarter 2007 report, which spells the word "trouble" across its pages. I can imagine what had happened with the already worrysome statistics during the last six months since the report's coverage. I thought it would be interesting to share several pieces of data from this report with the blog readers.

First, a couple of summary lines from the first page of the report:

This summary is basically saying that a degree of derivative and credit derivative exposure by U.S. banks was increasing at the double-digit quarter-to-quarter growth rates back in the second half of 2007 and that only a handful of banks dominated the scene in the banking sector's derivative market.

The following diagram from the report shows the trend in a value of total derivatives traded by U.S. commercial banks since 1990:

Whenever we see exponential growth (which is obviously the case on the graph above), we should note for ourselves that a correction is in order because no market growth can be sustained in the long run at the ever accelerating positive rates.

Now, here is a report diagram and a report table on a degree of credit exposure by the five largest derivative players among U.S. banks:

From the data above, you can get the idea who are the prime candidates for serious potential issues.

Finally, below are several summary report tables which show us mind-boggling figures about the extent of derivative, and CDS in particular, exposure of most major U.S. banks.

Note a discrepancy between the value of banks' total assets and the notional values of their derivative contracts. Because most derivatives are off-balance-sheet items and because the true exposures from such derivative contracts are not necessarily valued objectively and correctly at actual market prices, the banks get away just fine in their finanical reporting, leaving many investors oblivious of the ugly truth that lies beneath the surface and waits for the right market moment to get exposed (as it happened to Bear Stearns last week).

Speaking of Bear Stearns (we can legitimately call it a BS company now, I guess), keep in mind that the report's list includes only banks and not security dealers such as Bear Stearns, which all may be in even deeper mire than banks. Look at the guy on the top of the report's list of largest derivative players among banks. If the acqusition of the BS Co goes through as announced, JPMorgan will have an even bigger exposure in the credit derivatives market.

Look at JPM's credit-exposure-to-capital ratio. It is ridiculously high. Look at these ratios of the other top banks on the list above. I think that whoever has a credit-exposure-to-capital ratio above 50% is a good candidate for shorting, with those few banks which managed to get it above 100% being almost sure bets for trouble if the situation in the credit insurance markets gets really bad.

Look at the graph below to see how much exposure in the sub-grade credit derivatives the "top" banks (shall I say the "bottom" banks) have. Also, note that most of these contracts are 1-5 years in maturity which means that they are due to expire in 2008-2011.

If you do not see an issue here, then I do not know what can be called an issue. I will just name those banks that I think may be potentially facing very serious problems, on top of what they have had already due to the subprime crisis:

  • JP Morgan Chase (JPM)

  • Citibank (C)

  • HSBC Bank (HBC)

  • Bank of America (BAC)

  • Bank of New York Mellion Corp (BK)

  • State Street Corp (STT)

  • Wachovia Bank (WB)

  • Lehman Brothers (LEH)

  • Merril Lynch (MER)

  • If the CDS markets collapse for some reason (well, realistically there are very slim chances that it will happen because the government will bail out again), then the companies above will take the biggest hit. Please use your best judgement when investing in these banks.

    Graph and table credits: U.S. Office of the Comptroller of the Curency, Quarterly Report on Bank Derivative Activities, 3rd Quarter 2007.

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